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How High Should Top Income Tax Rates Be? What Andrew Fieldhouse Gets Wrong

Over at the Fiscal Times Andrew Fieldhouse has a go at answering the question, well, just how high should top income tax rates be? Sadly, he gets a few things wrong and these mistakes badly distort the answer he provides.

As you might imagine, his final answer is that income tax rates should be, at that top end, much higher than they are. This isn’t surprising coming from someone connected with the Economic Policy Institute. The general impression from them is that there’s nothing, from slow growth rates to toothache, that wouldn’t be solved with higher tax rates.

Most importantly, recent economic research has shown that productive economic activity is relatively unresponsive to increases in the top income tax rate, and the top income tax rate is well below the levels where it maximizes revenue. Economists Peter Diamond and Emmanuel Saez estimate that the revenue maximizing income tax rate is 73 percent (combing federal, state and local taxes).

No, that is not what that paper says. What it does say is that in a tax system
with no allowances then that peak of the Laffer Curve, that revenue maximising rate, is 73%. What it also says is that the peak in a system
with allowances is more like 54%. Further, this is not the income tax rate: this is including all taxes on income, including employer paid taxes on employment. Thus it includes the Medicare surcharge and so on. Thus this conclusion is incorrect:

As I explain in a
new paper, this implies that policymakers could raise the top federal
statutory income tax rate from 39.6 percent to roughly 66 percent before reaching revenue-maximization, meaning there is substantial scope for top rate increases without unduly burdening economic growth.

Because no one, absolutely no one at all, is suggesting that the US tax system be stripped of all allowances. Yes, most certainly, there are arguments that some of them should be curtailed. Perhaps a total amount per year, a maximum that can be claimed. Perhaps limits on money going into tax preferred retirement funds. But no one is talking about removing all allowances. Most especially things that Saetz and Diamond include in their definition of allowances: things like different taxation rates for capital gains and income. That is an allowance for once you get far enough up the income curve you do have a certain amount of choice in whether you take money as gains or income.

From this mistake we get to the point that yes, there is some room to raise higher income tax rates: if that’s what anyone desires to do. But once you’ve added Federal income tax of just under 40%, the Medicare surcharge and, say,
California or
New York (and especially NYC as well) income tax rates there’s really not all that much room before we hit that 54%, is there?

So, assuming that we do indeed want to increase the tax take we are, in certain parts of the country at least, very close to that revenue maximising rate. Which doesn’t leave us with a great deal of extra revenue to collect from raising said rate.

There’s a second problem here, one which is an example of Worstall’s Fallacy. Which you will remember is, looking at the extent of a problem without measuring the things we already do to try to solve that problem.

Raising top income tax rates from their relatively low current levels would be the least harmful policy option for deficit reduction and would potentially yield large reductions in income inequality growth.

That could be true. It might even actually be true. But we can’t prove it from the information provided. When we look at the source document from his paper,
this one, that discusses the change in income distribution and the association with taxation, we find a great glaring hole in the calculations.

What is the major method the US uses to try and redistribute income? That would be the EITC actually. So, any analysis of income distribution and how taxation changes it should look at the impact of the (very much expanded over the years) EITC. The paper does not do so: even though the EITC is a form of negative income tax, it entirely ignores its effect on the distribution of incomes.

Thus, what that paper is exploring is the effect on the income distribution before the things we do to alter the income distribution. However, before we decide that more should be done to redistribute income we need to know the effect of what we already do to redistribute income. Without that we cannot even begin to decide whether we should redistribute more, less, the same amount or just give up and go home altogether.

It has to be said that neither of these are uncommon mistakes in ruminations about what tax rates should be: but they are mistakes and we shouldn’t take propaganda in favour of higher taxes all that seriously while the propagandists are making these mistakes.

Footnote: Just for the avoidance of doubt I am not saying that top tax rates should be higher, or should not be higher. That’s very largely a political, not economic, question. I am saying that there are errors in this current argument being presented: and that’s all I am saying.

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